Capital Budgeting Techniques

Dr. Renu Sharma

What is Capital Budgeting
 The process through which different
projects are evaluated is known as capital
budgeting
 Capital budgeting is long term planning
for making and financing proposed capital
outlays”- Charles T Horngreen.
 “ Capital budgeting consists of planning
and development of available capital for
the purpose of maximising the long term
profitability of the concern” – Lynch
Characteristics of Capital
expenditure
 Long-Term effects
 Irreversibility
 Substantial Outlays
Difficulties
 Measurement Problem
 Uncertainty
 Temporal Spread
Types of Capital Investments
 Physical/Monetary/Intangible Investments
 Strategic/Tactical Investments
 Mandatory investments
 Replacement Investments
 Expansion Investments
 Diversification Investments
 R &D Investments
 Miscellaneous Investments
Phases of Capital Budgeting
 Planning
 Analysis
 Selection
 Financing
 Implementation
 Review
Pay Back Period
 It is the number of years required to recover
the original cash outlay invested in a project
Decision Rule:
The PBP can be used as a decision criterion to
select investment proposal.
 If the PBP is less than the maximum
acceptable payback period, accept the
project.
 If the PBP is greater than the maximum
acceptable payback period, reject the
Project.
Merits

 It is simple both in concept and application

and easy to calculate.
 It is a cost effective method which does not
require much of the time of finance
executives
 It is a method for dealing with risk. It favours
projects which generates substantial cash
inflows in earlier years and discriminates
against projects which brings substantial
inflows in later years . Thus PBP method is
useful in weeding out risky projects.
Demerits
 It fails to consider the time value of money.
 It ignores cash flows beyond PBP. This leads
to reject projects that generate substantial
inflows in later years.
Uses:
 The PB method may be useful for the firms
suffering from a liquidity crisis.
 It is very useful for those firms which
emphasizes on short run earning
performance rather than its long term
growth.
Accounting/Average Rate of
Return
 This method is also known as the return on
investment (ROI).
 The ARR is the ratio of the average after tax
profit divided by the average investment.
 The average profits after tax are determined
by adding up the PAT for each year and
dividing the result by the number of years.
 The average investment is calculated by
dividing the net investment by two.
Decision Rule

 If the ARR is higher than the minimum

rate established by the management,
accept the project.
 If the ARR is less than the minimum rate
established by the management, reject the
project.
Merits
 The ranking method can also be used to
select or reject the proposal using ARR. It
will rank a project number one if it has
highest ARR and lowest rank would be
given to the project with lowest ARR.
 It is simple to calculate.
 It is based on accounting information
which is readily available and familiar to
businessman.
Demerits
 It is based upon accounting profit, not
cash flow in evaluating projects.
 It does not take into consideration time
value of money so benefits in the earlier
years or later years cannot be valued at
par.
Discounted Cash Flow Criteria
Net Present Value (NPV)
 The NPV is the difference between the
present value of future cash inflows and
the present value of the initial outlay,
discounted at the firm’s cost of capital.
 The procedure for determining the
present values consists of two stages. The
first
NPV
 NPV = Present value of cash inflows –
Initial investment
 If the NPV is greater than 0, accept the
project.
 If the NPV is less than 0, reject the
project.
Merits
 It explicitly recognizes the time value of
money.
 It takes into account all the years cash
flows arising out of the project over its
useful life.
Demerits
 This method requires estimation of cash
flows which is very difficult due to
uncertainties existing in business world.
 It requires the calculation of the required
rate of return to discount the cash flows.
The discount rate is the most important
element used in the calculation of the
present values because different discount
rates will give different present values.
Profitability Index (PI)
 Profitability Index (PI) or Benefit-cost
ratio (B/C) is similar to the NPV
approach. PI approach measures the
present value of returns per rupee
invested.
 It is observed in shortcoming of NPV that,
being an absolute measure, it is not a
reliable method to evaluate projects
requiring different initial investments. The
Profitability Index (PI)
 It is a relative measure and can be defined
as the ratio which is obtained by dividing
the
present value of future cash inflows by
the present value of cash outlays.
Decision Rule
Using the PI ratio,
 Accept the project when PI>1
 Reject the project when PI<1
 May or may not accept when PI=1, the
firm is indifferent to the project.
Merits
 It considers time value of money as well
as cash flows generated by the project.
 At times, it is a better evaluation
technique than NPV in a situation of
capital rationing.
Demerits
 It requires estimation of cash flows with
accuracy which is very difficult under ever
changing world.
 It also requires correct estimation of cost
of capital for getting correct result.
Internal Rate of Return
 The internal rate of return (IRR) is the
discount rate that equates the NPV of an
investment opportunity with Rs.0
(because the present value of cash inflows
equals the initial investment)
 It is the compound annual rate of return
that the firm will earn if it invests in the
project and receives the given cash
inflows.
Decision Rule
 If the IRR is greater than the cost of
capital, accept the project. (r >k)
 If the IRR is less than the cost of capital,
reject the project. (r<k)
Merits
 It considers the time value of money and
it also takes into account the total cash
flows generated by any project over the
life of the project.
 IRR is a very much acceptable capital
budgeting method in real life as it
 measures profitability of the projects in
percentage and can be easilycompared
with the opportunity cost of capital.
Demerits
 It requires lengthy and complicated
calculations.
 When projects under consideration are
mutually exclusive, IRR may give
conflicting results.